As lenders, hedge funds draw new scrutiny - Business - International Herald Tribune

In early March, executives from Movie Gallery, a big movie rental chain, held a private conference call for their lenders to talk about how disastrous 2005 had been for the company.

A string of Hollywood flops had kept customers away. More people were recording movies from television instead of renting them from stores. The executives said they needed more time to fix the problems, which included more than $1 billion in debt.

Most of the roughly 200 lenders were not bankers but hedge funds.

And what they heard was supposed to be confidential. It was inside information, as valuable to investors as a tip about an imminent takeover.

During the next two days, though, Movie Gallery's shares were heavily traded, and its stock plummeted 25 percent.

A coincidence? Regulators are not so sure. The Securities and Exchange Commission is looking into whether any of the hedge funds taking part in the private call with Movie Gallery took their inside knowledge of the company's struggles and traded on it. Movie Gallery announced earnings results to the public nearly two weeks after the private conference call.

The Movie Gallery case provides a window onto the growing power of hedge funds in financial markets, and it raises questions about their role in how information flows on Wall Street. Hedge funds have become a dominant force in the New York and London stock exchanges and now account for roughly half of all trading in those markets. But they also have recently become major players in the more opaque debt market, which includes bonds as well as loans and is more than one and a half times the size of the stock market.

"If hedge funds are privy to inside information and they invest in different securities all over the capital structure, this raises lots of concerns," said Alistaire Bambach, assistant director for the northeastern regional office of the U.S. Securities and Exchange Commission. She declined to comment on any open investigation.

The power shift in the loan market has spurred the trade association for lenders to develop guidelines, which were to be announced Monday, on how confidential and potentially market-moving nonpublic information can be used.

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"There are laws against insider trading: you can't trade securities on the basis of material nonpublic information," said Elliot Ganz, general counsel of the industry group, the Loan Syndications and Trading Association. That goes for hedge funds as well as any other entity that owns or trades loans.

Lending was once a clubby world dominated by banks, which are highly regulated and go to great lengths to separate their various lines of business. To keep bankers from possibly sharing inside information with traders, some banks even separate their divisions on different floors and use coded identification tags to restrict access.

But hedge funds, which do not generally face such strict regulatory oversight, tend to be smaller than banks and have fewer information barriers. At some funds, the person trading loans, who may have access to confidential information, might sit next to the person trading the bonds - in some cases, they may even be the same person.

"You can't put an ethical wall down the middle of someone's brain," said Herbert Bohnet, a lawyer at Ropes & Gray who represents hedge funds.

Many hedge funds have put in place information barriers to guard against trading on inside information. Silver Point, a $6 billion hedge fund focused on investing in various kinds of debt, physically separates the people who have inside information from those who do not, among other measures. "Silver Point has a sophisticated information barrier," said Adam Weiner, a spokesman for the fund.

Some funds choose to restrict their trading. For example, Highland Capital Management, a $28.5 billion investment management firm that operates hedge funds, and Silver Point each say that when their public side receives any nonpublic information about a company, it restricts itself from trading any securities in that company. Other funds, to avoid even the appearance of having a trading edge, simply opt to receive only public information.

The hedge fund business has exploded in recent years, with more than 9,000 funds now managing more than $1.2 trillion for pension funds, endowments and wealthy individuals. Part of the appeal to these sophisticated investors is the funds' greater freedom to bet on different markets, including exotic and risky investments. Many institutional investors use them to diversify their portfolios.